Pattern Day Trader Workaround: Tips and tricks you need to know
You’ve heard the saying, ‘look both ways before you cross the street.’ Well, you better take a look at the pattern day trader rule before you jump into equity trading.
Within corporate America, regulatory requirements are a gift and a curse: they help certain industries, while leaving others in the dust. For the individual investor, it’s no different. If you’re not up to code, you’ll get hit.
But don’t worry we’ve got you covered. We’ll provide you with a pattern day trader rule workaround kit, with all the tools you need to get your trading-game up and running and avoid regulatory scrutiny. This is the perfect addition to our comprehensive guide pattern day trader rule explained.
The US Securities and Exchange Commission defines a pattern day trader as a margin account holder who “executes four or more day trades within five business days” given the trades represent “more than six percent” of total trades within the same time period.
The rule -- instituted by the US Financial Industry Regulatory Authority (FINRA) -- requires that anyone deemed a pattern day trader can only trade in a margin account and must maintain a minimum balance of at least $25,000.
Is pattern day trading illegal?
Not if you follow the requirements. If you keep your margin account above $25,000 -- which can be a combination of cash and securities -- you’re fine.
However, if your margin account drops below $25,000 your broker will suspend your trading activity until the minimum balance is restored.
Does the pattern day trader rule apply to options as well?
Yes. The rule applies to all financial securities. Even though you’re not technically using margin, options have embedded leverage which makes them subject to the rule.
It’s like this: when you sell options, you take on the liability to buy the stock (if puts are exercised) or sell the stock (if calls are exercised).
Thus, you’ll need excess cash to fulfil the obligations. For that reason, the requirement is still there.
Day trading rules for accounts under $25,000
This is where analysis gets tricky. Remember, the pattern day trader rule only applies to margin accounts (recommended read: What is buying on margin). It also applies when day trading penny stocks and independently from your day trading strategies like the gap and go strategy. The rule depends only on your trading activity.
So can you be a pattern day trader in cash account?
The short answer is – no. If you’re not using leverage you don’t need to worry about the rule.
However, FINRA – being the watch-dog that it is – doesn’t let you off the hook that easy. It still muddies the water with other technicalities to make day trading difficult.
Think of it like this: In a cash account there is no leverage (don’t worry it’s bad for you anyway).
Yet, the Federal Reserve still employees a regulatory rule called the freeriding prohibition. The rule stipulates an investor can’t use ‘unsettled funds’ to engage in another transaction.
Most brokerage trades function like this:
The T+2 is key. Trades take two business days to settle. This is where the brokerage transfers cash from your account to the seller, and transfers securities from the sellers account to you.
When day trading, transactions occur so fast that you’ve already bought and sold the stock – or other asset – before an official settlement can take place.
So, while day trading is not prohibited in a cash account, the freeriding rule makes life very difficult.
How to day trade with less than $25,000
We know the requirements, now how can we avoid the pattern day trader rule?
Use multiple brokerage accounts
The pattern day trader rule restricts trades to less than four within a given day. If you have multiple accounts – with different brokers -- you can enter offsetting positions and still be in compliance.
The strategy is a little problematic though; you’ll need to monitor multiple positons and accounts which may result in trading inefficiencies.
Pool money together
By pooling money together with family or friends, you can execute your strategy and still maintain the $25,000 minimum.
However, like using multiple brokerage accounts, this isn’t an optimal strategy. You’ll need to set the account up as a business account, which results in many other regulatory hurdles.
However, as a pass through entity – similar to a mini hedge fund – it will provide the same financial benefits as an individual account. Of course, if you go this route, it’s best to consult an entrepreneurial or business lawyer to ensure you’re not violating any laws.
Join a day trading firm
This one is probably out of reach for most, but if you’re highly skilled you could join a day trading firm.
Here, the company finances your positons – similar to a proprietary trading desk at a large bank – and you receive a percentage of the profits.
The strategy requires a firm to believe in your skills, and of course, will come with a lot pressure to perform. But hey, this route is a pathway to the big time; so if you have what it takes, it’s worth a shot.
Increase your holding period
Within a margin account, if you hold your positions overnight you can work around the pattern day trader rule. Since the terms cover intra-day trades, if you increase your holding period, you can still participate with an account less than $25,000.
In all honesty, a longer holding period is not a bad thing. Commission charges eat away at profits rather quickly, so by increasing your investment timeframe, your costs will decline. This can also allow you to fully capitalize on momentum.
Unless a material event hits the wire – which I’ll admit, in todays’ market happens a lot – most trading days tend to follow a constant bullish or bearish theme. Holding your position throughout the day can be a way to take full advantage of this.
Trade in less regulated markets
Most foreign countries – especially emerging markets – have less regulation and financial market oversight. If you use a broker located in Europe, Asia or even Canada you can circumvent the pattern day trader rule.
While Canadian Securities Law still requires a margin account for short-selling, it has no pattern day trade rule and the minimum margin requirements are less stringent.
Undoubtedly, this is your best option.
Many foreign brokerages have reliable services and can provide you with the flexibility you need. The only downside is currency risk.
By opening accounts denominated in foreign currency, you risk translation losses – similar to a multinational corporation that operates in foreign markets.
However, there are options to hedge the currency.
On the exchange, you can sell currency futures contracts and lock in a conversion rate.
While the notional amount won’t be known at the time – it depends on your trading profit and loss – you can estimate the amount and cover yourself within a certain degree of confidence.
The position can also be financed rather cheaply. Similar to selling put options, you’ll be required to post an initial margin. Then, as the contract ‘marks-to-market’ additional maintenance margin will be required to cover any losses.
However, if your position increases in value, you won’t be required to post additional margin as you’ll be in good standing.
Pattern Day Trader Rule Workaround Summary
As lined out in our lead-article "Day Trading for Beginners", day trading is a competition and there are some hurdles to be mastered. However, if you are well prepared, then day trading is much more efficient than starting without a plan.